Fuel price controls vs. climate change

Sometimes, government policy just makes little sense. And sometimes, the economic model that you have in your head doesn't help. Take the example of fuel price controls, which Timothy Welch (University of Auckland) wrote about in this article in The Conversation last week:

The government announcement that the Commerce Commission will soon have the power to regulate wholesale petrol and diesel prices might be good news for cash-strapped motorists, but it’s arguably a retrograde step in the fight against climate change.

While there is some scepticism about whether the commission will ever act to enforce fuel price caps, any move to make carbon-emitting vehicles more affordable must come at the expense of efforts to encourage people out of cars and into more sustainable modes of transport...

Aside from being counter to other plans to mitigate climate change, there is plenty of evidence that price caps can often cause outcomes opposite to those intended. Sometimes, leaving it to the market can be the better option. 

Let's look at this. If the government puts a price control on a perfectly competitive market, we can illustrate its effect with the supply and demand model, as shown in the diagram below. The equilibrium price of petrol is equal to P0, and Q0 petrol is traded. The government thinks that price is too high, so (through the Commerce Commission) they implement a price ceiling (a legal maximum price) of PMAX, which is below P0. The consequence is that the quantity of petrol demanded increases to QD, but the quantity of petrol supplied decreases to QS. There is a shortage of petrol, and only QS petrol is traded.

So, with the price control, less petrol is traded than without the price control. That seems like a win-win for consumers and the climate, and would suggest that we should not be concerned. However, there are two problems here. First, many consumers would be missing out on petrol (there is a shortage at the price ceiling of PMAX). So, it doesn't make all consumers better off. However, the second problem is more fundamental. The market for petrol is not perfectly competitive. While I have argued before (for example, here) that the supply and demand model is usually robust to situations where the market is not perfectly competitive, government intervention in the market is an exception. The firms in the market for petrol have some market power, because they differentiate themselves (on the basis of branding, and the location of their outlets).

A more correct model is shown in the diagram below. The firm with market power operates at the profit maximising quantity, which is the quantity where marginal revenue is exactly equal to marginal cost. That is the quantity Q0, and in order to sell Q0, the firm charges a price of P0 (because with a price of P0, consumers will demand exactly Q0 units of petrol, which is the quantity that maximises profits). When the government implements its price control at PMAX in this market, the price falls, and the quantity of petrol traded increases to Q1. Unlike in the perfectly competitive market, a firm with market power is willing to satisfy the additional consumer demand at the lower price by selling more. So, if the market for petrol has some market power (which we know it does - it is an oligopoly), a binding price control would induce consumers to buy more, with greater impacts on the climate.

However, that isn't the end of the story. The government isn't proposing a price control on retail petrol, but instead on the wholesale price. The analysis above doesn't quite capture that. So, instead of a price control on a firm with market power, we should be showing what happens when a firm with market power has lower costs (because a lower wholesale price of petrol would lower the retail petrol outlet's costs). This is shown in the diagram below. Without the price control, the firm's costs are shown by the line MC0=AC0. The firm profit maximises with a price of P0, and sells Q0 petrol. After the price control is introduced, the firm's costs decrease to the line MC1=AC1. The new profit-maximising quantity is Q1, and the new profit-maximising price is P1. The firm with market power passes on some of the cost savings to consumers in the form of a lower price of petrol (which is what the government intends), and the consumers respond by buying more.

For a government that has stated that climate change is this generation's nuclear free moment, this seems like a very odd policy choice. However, understanding why relies on having the right economic model in mind. And that would be very important if Welch got his way and we had:

...some robust debate about whether the new Commerce Commission powers are necessary. That will involve asking whether making fossil fuels more affordable runs counter to our climate change goals, and whether we are trading planetary health for short-term economic relief.